How
many mutual funds are needed for a well-diversified portfolio? -
Commentary

For holding periods of many years, diversification improves
dramatically, when you hold multiple actively-managed mutual funds in
an investment portfolio.

In "How Many Mutual Funds Constitute a
Diversified Mutual Fund Portfolio?," Professor Edward O'Neal of the
University of New Hampshire at Durham tackled the important question of
how much an investor could improve on diversification by holding
multiple actively-managed mutual funds within an investment portfolio.1

Because individual investors typically stay invested in particular
actively managed mutual funds for many years, a terminal valuation
approach is useful in understanding the variability of outcomes for a
mutual fund buy-and-hold strategy.

Professor O'Neal found that, if one looks only at average
year-to-year portfolio risk or volatility, then adding more mutual
funds to a portfolio seems to improve diversification only very
slightly. However, if you look at terminal investment portfolio values
after multi-year investment holding periods, then very substantial
reductions in investment risk can be achieved by owning multiple
actively-managed mutual funds.

Professor O'Neal pointed out that individual investors plan for
college or retirement expenses with long investment horizons. They are
most concerned with the likelihood of achieving their end-of-period
investment goal. Therefore, the variability of cumulative returns at
the target time or the "terminal wealth" is of greatest concern to
these investors.

Professor O'Neal compared actively-managed mutual funds with similar
styles, i.e. "growth-and-income" style mutual funds and "growth" style
mutual funds to determine the value of increased diversification within
a particular investment strategy, rather than across several strategies.

Over long investment holding periods, uneven performance from one
mutual fund and another can be very dramatic and can result in a wide
range of total investment returns.

Professor O’Neal noted that “the average growth fund
return over the 19-year period was 1,502 percent, although the
distribution is skewed to the right (the range was 543 percent to 6,794
percent).”2 This means that the best performing growth
mutual fund returned over 12 times that of the worst performing growth
fund that had survived for the full 19-year period.

The worst surviving growth mutual fund was undoubtedly not the worst
growth mutual fund overall, because the Morningstar data has a
'survivorship bias.' The Morningstar data used only included mutual
funds that were in business throughout the entire 19-year period.
Mutual funds that were such poor performers that they had been put out
of their misery during this period were not included in the data. This
means that the actual average performance across all actively managed
growth funds was even lower than that of just the survivors.

The performance of the vast majority of actively managed mutual
funds tends to revert over time toward the average, and those mutual
funds that will eventually have higher investment returns are
impossible to detect reliably beforehand.

If an investor wishes to narrow down significantly the range of
variation in long-run terminal investment portfolio performance, then
investing in multiple funds of similar investment style seems to be a
much more reliable strategy than investing in just one fund. Investing
in just one fund and hoping for the best is not an optimal strategy
from the standpoint of risk-adjusted investment performance.

When an investor holds a group of actively managed mutual funds,
the long-term performance of that group is more likely to move closer
to approximating the relevant market index benchmark - but at a much
higher cost that index mutual funds and ETFs.

Ranked by the number of different securities held, the 50th
percentile growth style mutual fund in the Morningstar data held 78
securities in 1994. Depending upon the degree of common holdings of
particular stocks across funds and the relative weightings of those
holdings, when you own multiple actively managed mutual funds of a
similar style, it is likely that long term investment performance
results will move closer to the relevant index benchmark. Largely
because of their excessive costs, it is unlikely for actively managed
mutual funds to beat passively managed index mutual funds on a
risk-adjusted returns basis.

A passive index fund alternative always exists and has much lower
costs. The performance variability among passively managed index mutual
funds and index exchange-traded funds is dramatically lower. Investors
who stick with multiple actively managed funds that approximate an
index are guaranteed to have lower returns, because they pay the higher
fees of active funds, while their performance tracks the benchmark.

As the holdings of multiple mutual funds begin to approximate the
benchmark index, high fees and tax inefficiency become far more
important considerations. The alternative to holding a larger number of
actively managed mutual funds is to hold a smaller number of passively
managed index mutual funds and index ETFs. Index mutual funds and ETFs
provide broader diversification with lower fees, taxes, and time
commitments.

There is a better way to invest than owning one or many
actively-managed mutual funds. However, to improve your investment
strategy, you have to abandon the false notion that you are likely to
pick winning actively-managed mutual funds and beat the other guy. Only
by luck to a minority of individual investors pick "winning"
actively-managed mutual funds. Most pick losers, because most actively
managed mutual funds are losers, when compared to index mutual funds
and index exchange-traded funds.
(For example, see: Standard & Poor's Indices Versus
Active Fund Quarterly Scorecards)